How to Build A Trading System Part 5

- 25 August 2011

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Over a number of previous MarketPulse articles, we have discussed the various steps which traders need to go through to design a robust trading system. As a recap, a trading system contains a series of conditions which need to be met before we enter a trade. When these conditions are met we are said to have a ‘setup’. Setups are an integral part of our trading plans and are essential to improving our consistency and performance in the markets.

Over the next couple of weeks we will attempt to put everything together, and design a trading system which readers might actually wish to implement for themselves. We’ll also point out a few important practical considerations traders need to take note of when designing and testing a trading system.

System 1 – Simple, but effective

As we said in the last article on this topic, systems need to have objectives. The objective of the system we will design and test today is to capture major long term swings in the market the system is operating on. Generally such systems are trend-following systems which have wide stops and open-ended targets. This trading system would be suited to a long term investment portfolio or a self managed superannuation fund.

Whilst this might not sound too exciting for many of you ‘seat of your pants’ traders out there, we conduct this analysis to show how timeframes and objectives are important in successful system design. We will test some shorter term systems in future weeks.

Once we have our objectives, we must begin to construct the ‘Framework’ we described in Part III of this series of articles.

1. The trading system needs a set of rules for entry.

Any long term trading system should first and foremost start with defining and following the long term trend. Our proxy for the broader trend will be the 100 period moving simple average (ma). So, Condition 1 for our set of entry rules becomes:

Long term trading system – Entry Rules

Condition 1

Before a long entry can be considered, the 100 day moving average must be at its greatest level in the last 20 periods, and the last closing price must be above the 100 day moving average.

What the above should do is only put us in trades where the long term trend is up, and the trend is still in place (as the 100 day ma has been rising over the last 20 periods, and the price is still above the average).

On top of this basic condition, we will now add further conditions or ‘filters’ to improve the effectiveness of our overall entry signal. For this system, we are going to try and filter out trades where the shorter term momentum is not strong – even though Condition 1 may have been met.

Condition 2

Buy when the 20 period ma crosses above the 40 period ma, or if a cross up has occurred within the last 40 days, then the 20 day ma must still be above the 40 day ma.

An entry signal will occur when each of the above conditions are met. We talked in Parts III and IV about ‘setups’ and the above is an example of purely technically based trend setup. We think that there is more to a setup than just the entry signal however, and each setup should be considered in terms of risk and reward, and where we can place our stops.

Only fools rush in…

An entry signal is only a small part of a trading system. As we showed in the case of the coin toss example in Part I, it is also sometimes the least important element of a system. This brings us to items 2, 3, and 4 of our Framework.

2. The system needs a set of rules to determine how we take profit,

3. The system needs a set of rules to determine how we take losses, and

4. The profit we take should be larger than our losses.

A trade setup consists not only of the entry signal, but also some consideration of where a stop loss can be safely placed, and how much we are risking at that stop loss compared to the potential profit we may make if we are successful.

We feel that with trend based systems, we’re better off just letting our profits run and letting the market decide how much profit we eventually take. For such systems, whilst we might have a ‘loose’ target in mind, we prefer not to set a hard-and-fast point for where to exit at a profit.

For stops, we are prepared to give the trend based system some room, but we also have a motto when it comes to the relationship between setting stops and setting profit targets:

“Whilst we are brave in victory, in defeat we run like frightened animals!”

This means that whilst we like to let our profits run, we want to keep our losses as small as possible. This will help in building a system with positive expectancy.

We have discussed each of the above elements of the Framework in detail in previous articles, and based upon those considerations and the ones above, we will add the following conditions to our trading system:

Long term trading system – Holding and Exit Rules

Condition 3

Initial stop loss is to be placed 2.5% below the 40 day moving average.

Condition 4

Stop is to be trailed higher each day to 2.5% below the 40 day moving average at the conclusion of each trading session.

We have now defined each element of the setup, from entry to stop placement. So what do we do now? How do we know if the system is any good!?

Well you might want to start testing this system on a few stocks, FX pairs, or commodities to see how well it works. However rather than calling up the bank manager and taking out a second mortgage on the house to have a go, you may prefer to take the approach most professional traders will when testing a system and run a ‘back test’.

A back test is a simulation of how a trading system performed on historical data. We will choose a sample of data and record in meticulous detail each entry and exit for the system based upon its explicit rules. By summing the results of many trades over an extended period of time, back testing allows us to get an idea of how effective a system has been in the past.

Back testing itself is a major field of technical analysis, and if performed correctly, it can also give us some valuable insights into how a system may perform when we trade it live with real money in the future.

Next week we’ll do just this and investigate how well the above system is likely to work in practice. Until then – happy testing!

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